Last week we discussed taking advantage of market volatility and the old adage “buy low” rather then “sell low.” Today we will discuss the disadvantages of investing in cash or “guaranteed” investment deposits. While investors think they are playing it safe, they are actually risking losing money. Those investors who move to cash aren’t just missing out in potential gains, but are also susceptible, in this low-rate environment, to a steep rise in inflation. Look at the astronomical rise in some of our most essential commodities like energy and food within the last few months.

The erosion of real income has not been front and center in the minds of many Canadians as in previous decades. If you visit the Bank of Canada website, you will find an inflation calculator which uses consumer Price Index data from 1914 to show the changes in a fixed “basket” of consumer goods. Since 1914 inflation has averaged 3.2% per year over the last 94 years. From 1993-2004 inflation rose 1.8% per year which has made us somewhat complacent about the effects of inflation. Inflation rose, to April 2008, to 2.1% a year. A small increase, but with the steep rise in the cost of oil which effects just about ever facet of our lives from filling up our vehicle at the pumps, heating our homes or buying those fresh fruits and vegetables at our local supermarket, we can see the trend to higher inflation unfolding.

To add insult to injury the tax rate on interest income is much higher than income dividends or particularly capital gains. The overall effect is that after taxation and inflation there is significant risk of negative returns on cash investments.

There are those investors who try to time the market, but the difficulty there is that they have a tendency to sell after the market has made a correction therefore realizing on their investment after it has dropped in value. They then have a tendency to buy back in after the markets have started to rebound and have missed out on some of the largest gains.

There will always be investors who just don’t have the risk tolerance for today’s market. It is the advisor’s job to help them find a happy medium to put them in the right investments for their comfort level.

For the long-term investor saving for retirement, ultimately staying invested during volatility in the market makes the most sense. If possible a strategy of setting up an installment plan that will provide dollar-cost averaging to their contributions can minimize the effect of volatility.

August 8, 2008